What is invoice factoring and how does it work?

What is invoice factoring?

Invoice factoring is type of invoice finance where you "sell" some or all of your company's outstanding invoices to a third party as a way of improving your cash flow and revenue stability. A factoring company will pay you most of the invoiced amount immediately, then collect payment directly from your customers. There are benefits and disadvantages to invoice factoring, which we'll cover in this article.

Invoice factoring is also referred to as accounts receivable factoring or debt factoring.

How does factoring work?

Invoice factoring means selling control of your accounts receivable, either in part or in full. It works like this:

1. You provide goods or services to your customers in the normal way.

2. You invoice your customers for those goods or services.

3. You "sell" the raised invoices to a factoring company. The factoring company pays you the bulk of the invoiced amount immediately, typically up to 80-90% of the value, after verifying that the invoices are valid.

4. Your customers pay the factoring company directly. The factoring company chases invoice payment if necessary.

5. The factoring company pays you the remaining invoice amount – minus their fee – once they've been paid in full.

When should your company use factoring?

Your company should use invoice factoring when you routinely have a lot of invoices outstanding and your cash flow is suffering because of it.

As an example, say your organisation sells on 30-day payment terms. Most of your debtors will pay within 30 days – some may require chasing, some may not – while others may go over the limit and require more persistent effort on your part. That 30-day chunk of revenue might represent the bulk of your potential cash flow, but you can't actually use it. Invoice factoring allows you to release that cash almost immediately, or at least a large part of it. You could use that money to:

• Bridge short-term expenses

• Repay a loan

• Take advantage of seasonal business opportunities

• Or for any reason for which cash flow might otherwise be a constraint

Advantages of factoring

• Improved and more predictable cash flow - By using invoice factoring, you can have the bulk of your invoices paid almost immediately rather than having to wait for the money to come in (potentially after extensive chasing on your behalf). It makes business planning and forecasting more accurate and allows you to take advantage of opportunities that might otherwise be unaffordable.

• Better chance of your business surviving - Better cash flow gives your business a better chance of survival. Many businesses fail due to poor cash flow, and invoice factoring can keep yours healthy – as long as you use it wisely.

• Cheaper and easier than a bank loan - Invoice factoring is usually cheaper than a bank loan and easier to obtain, making it good for short-term funding needs. It also takes the hassle of debt management out of your hands. Depending on the size of your customer base, that could be a big saving.

• Reduces your business overheads - Invoice factoring services could reduce your business overheads. While there are fees associated with invoice factoring, they may be less than the cost of paying dedicated credit control staff. Invoice factoring may also improve the morale of people working in your accounts department, as chasing payments is often stressful work.

Disadvantages of factoring

• Unsuitable for businesses with few customers - Invoice factoring isn't suitable for companies with only a handful of main customers. Factoring companies prefer to spread their risk as widely as possible. They try to avoid a high concentration of invoices to just a few customers.

• Requires a big commitment - Although it's sometimes possible to factor a small number of invoices (known as selective factoring or spot factoring), most factoring companies will want to take over the bulk of your accounts receivable. They may also try to tie you into a long contract, which could be two years or more. This is necessary from their perspective, but it means you can't just dip in and out of invoice factoring at any time. It's a major business decision.

• Costs more if your customers are risky - Factoring companies do their best to accurately determine the risk of late payment or non-payment of debt. This means they will assess your customers carefully. Their fees will reflect their perception of credit risk - if you or your customers are deemed high risk, fees will be high.

• Extra costs when it doesn't work - There may be extra disbursements to pay if your clients turn out to be worse payers than expected. If a customer fails to pay, you may have to repay the amount the factoring firm has already paid you, unless you pay extra for non-recourse factoring. In short, don't expect a factoring company to take over your bad debts for nothing. They're in business to make money, just like you.

• Can harm your relationships with customers - When you factor invoices and the credit control is handled by the factoring company, you are handing over some of the control over your customer relationships too. If the factoring company pursues the debt in a cold or aggressive manner, you risk your customers being put off working with you in future. They may also view the involvement of a factoring company as a sign your business isn't doing well.

Glossary

Accounts receivable

Accounts receivable is the money that a business is owed by its customers. This owed payment stems from the common behaviour of businesses supplying goods or services before being paid, under the agreement they will be paid shortly after they deliver what they promised.

The term ‘accounts receivable’ is also used to refer to the act of ensuring a customer pays the money they owe, and in this sense is often used interchangeably with ‘credit control’, ‘debtor management’, and ‘debtor tracking’. Typical ways of ensuring a customer pays the money they owe are giving them reminders via email or phone call, both before the money is due and after.

Accounts receivable factoring

Accounts receivable factoring is another term for invoice factoring - a type of invoice finance where you "sell" some or all of your company's outstanding invoices to a third party as a way of improving your cash flow and revenue stability.

Approval period

The expected time for invoices to be paid. Any debts older than this may be recoursed back to you.

Cash flow

Cash flow is a measure of the amount of funds coming into a business in a given time period (typically a month). Cash flow may be either positive or negative, depending on whether the business is bringing in more or less money than it spends in that period. While positive cash flow is a good sign, having a very high cash flow could indicate a business isn’t investing enough in its own growth.

CHOCC factoring

CHOCC factoring is a type of invoice factoring where you still chase payment for the invoices you've factored, rather than the factoring company doing so. CHOCC is an acronym meaning ‘Client Handles Own Credit Control'.

Confidential factoring

Confidential factoring is a type of invoice factoring where your customers are never made aware that they're dealing with a factoring business.

Credit control

Credit control is act of ensuring a customer pays the money they owe. It is often used interchangeably with ‘accounts receivable’, ‘debtor management’, and ‘debtor tracking’. Typical ways of ensuring a customer pays the money they owe are giving them reminders via email or phone call, both before the money is due and after.

Debt factoring

Debt factoring is another term for invoice factoring - a type of invoice finance where you "sell" some or all of your company's outstanding invoices to a third party as a way of improving your cash flow and revenue stability.

Disbursements

Additional fees charged by the factoring company for administrative issues, credit checks, etc.

Disclosed factoring

Disclosed factoring is the typical type of invoice factoring, where your customers are aware they're dealing with a factoring business.

Invoice finance

Invoice finance is a collection of ways to monetize your outstanding invoice, which involve being fronted a percentage of the invoice's value by a third-party for a fee, with the party being repaid upon collection of the invoice.

Non-recourse factoring

Non-recourse factoring is a type of invoice factoring where bad debts are not charged back to you by the factoring company. Fees will be higher than for recourse factoring.

Payment terms

Payment terms refers to the agreed timeframe your customer has to pay you after you have invoiced them. Common payment terms are 30 days, 60 days, and 90 days (that is, payment is due 30, 60, or 90 days after you deliver your goods or services and issue the invoice to your customer).

Recourse factoring

Recourse factoring is a type of invoice factoring where bad debts are charged back to you by the factoring company.

Selective factoring

Selective factoring is a type of invoice factoring where individual or small bundles of invoices are factored, as opposed to large amounts or the entire sales ledger.

Spot factoring

Spot factoring is a type of invoice factoring where individual or small bundles of invoices are factored, as opposed to large amounts or the entire sales ledger.